Frequent thinker, occasional writer, constant smart-arse

Category: payments

Why Bitcoin (or another deflationary currency) will lead to an economic revolution

In the 1500s, a turning point occurred in humanity. The British and Dutch empires adopted a new concept, that enabled them to take over the world and change it in the process. Their powerful new weapon? The notion of credit, where they abandoned the idea that the old was sacred. By “borrowing” against future prosperity — through credit — they overtook their rivals.

In our lifetimes, we are about to see another transformation. And ironically, due to the opposite reason: where borrowing against the future will be stopped. What’s that got to do with Bitcoin? A lot.

Every man and his dog is talking about Bitcoin and crypto currency. But one thing few people seem to talk about, let alone understand, is that Bitcoin has a fixed supply — specifically, 21 million. Which means that one day, unlike fiat currency, there will be no more “Bitcoins” printed out for the world, which makes it deflationary. If Bitcoin becomes the Store of Value in the world like I optimistically predict,  what will a deflationary world look like? A world where prices, like what you pay for in shops and what you get paid as salary, are decreasing? What’s that going to do to the economy? Four years ago, I made an attempt at saying deflation was a good thing (or rather, didn’t matter) but I didn’t get to the meat. I’m going to make another attempt at it this time (although many other people are still convinced it’s a problem).

Let’s unpack it. First let’s start with the concept of inflation itself.

Inflation
Here’s a question most people don’t seem to be able to explain. Why do governments, like my tax masters the US and Australia, make 2% inflation a “target”.

Inflation is basically when prices rise and there is a corresponding decrease in value of your cash to purchase — so the US and Australia have it as official economic policy to see prices rises by 2% each year. Short term, it means producers of output get more money, which makes economic output higher. But eventually, labour costs catch up so it’s a neutral impact on the economy. That is, in a best case scenario.

If expectations are managed, this can help jump start an economy short term, useful for elections. But really what’s happening is that long term inflation erodes the value of people’s savings (as their purchasing parity drops) while at the same time it reduces the effective value of debt (for a similar reason). So basically, for a long term “neutral impact” on the economy, debt holders are rewarded and hoarders of cash are penalised.

Debt funds consumption and investment, which grows output in an economy. Savings are a leakage from the economy which do the opposite. So in this sense, this political philosophy broadly speaking, is aligned with growing the system.

Meaning, inflation is evil, but in a good kind of way so we encourage it if we can control it.

Let’s now look at the real question: what’s economic growth?

Economic output
How do you grow an economy? The easy answer is that exports bring cash into an economy, but what about actual global output? If we take out this artificial growth, which is a transfer of cash between economies through trade, what actually creates net growth?

It basically comes down to two things: productivity improvements, which is doing the same thing cheaper (so that extra cash can go to other things), and population growth, which means there are now more people to consume in the economy. More people also means more workers, and remember, labour is a factor of production so the more available people (and time we have), the more we can produce. If we can pair productivity growth to population growth, we get economic growth: as we have more available cash to hire more people, they in turn can produce more output (if we assume the marginal output of labour put to work is higher than the marginal saving from productivity). By the definition of GDP, which is based on consumption, more goods being output and more people consuming means voila: more economic activity.

But that’s not the only thing that can brings cash into a system to fund consumption. Enter debt.

Debt
The invention of credit created the world we know today. But a thing that makes me scratch my head is how every government and citizen in this world seems to be in debt. If you look at the estimates, there isn’t one “bank” — every government seems to be in debt. Which basically implies one thing: we are borrowing money that will be paid by future tax, or the future income of citizens.

In the present, this is great: we have another form of cash injection into the economy, but for the future generations, this is effectively a leakage as their earnings are taxed.

Which brings us to the magic of inflation: that debt will get eroded, by a compounding amount, so that it’s practically non existent 2-3 generations from today. Assuming of course, the highway robbery from cash holders continues and inflation is constant.

But not with Bitcoin.

Bitcoin’s economic impact
With a deflationary currency that rules the world, cash holders will get rewarded for saving, as sitting on their economic value will increase with time. Inflation targets will now become deflation targets, but for the same goal of price stability. Instead of prices creeping up each year, they will creep down each year. More significantly,  debt will no longer be in the equation: as debt will only get more expensive over time (due to its purchasing parity) and it’s utilisation will drop.

Shock! Horror! The Kenyesian’s approach by Governments around the world to boost the economy will be eliminated! However, not all is lost. If investments can return a higher rate than what a saver would get hoarding their cash, then investment will still occur in the economy. And with investment, comes not just more cash into a system but also innovation, which might spark productivity improvements. This increases economic output.

Governments will be forced to stop abusing their position to borrow money to be paid by future generations, and instead, investment managers and entrepreneurs who can execute a higher return than deflationary returns, will instead be the custodians of increased economic output.

Which puts creativity, risk taking, and ingenuity, as the sole creator of economic prosperity. Which is how it should be: it’s making the competition of good ideas the thing the drives us forward.

In the process, this will make creativity the new scarcity, which is a powerful concept because it is less scarce than gold or fiat currency today. If Bitcoin or another currency with a fixed supply becomes the Store of Value in the world, this will usher in a new economic age that will be more pronounced than what the invention of credit did for the world.

Contrary to what people say, Bitcoin doesn’t have a deflationary problem: it’s actually got a built-in feature to unlock human potential, by strapping a rocket ship to our economy.

Bitcoin as Store of Value

JP Morgan Chase CEO Jamie Dimon, on the back of China’s announcement to throttle cryptocurrency, made comments yesterday that shook the market.  (It’s not the first time he’s done this.)

He supported blockchain technology for tracking payments but then goes onto to say it’s illegal to trade Bitcoin at the bank and that’s it’s a currency that is associated with criminal activities.

It’s comical to hear this. How can the CEO of a Bank, both support Blockchain (the thing that Bitcoin invented) but trash Bitcoin? To me it points to one very obvious fact: Bitcoin itself is a threat and he’s on a consistent PR smear campaign.

Why Bitcoin is a threat
Customer deposits, where people store their money for protection, is the basis of banking. Banks use those deposits to then do lending activities that actually make them money, such as lending up to 10x what they hold as deposits in the forms of mortgages. Those same lending activities, not only make them money but can also be packaged into new financial products, such as mortgages bundled into securities (like the ones that created the 2008 credit-crisis).

Why is Bitcoin a threat? Because it has the potential to fulfill a function that only government fiat currency and gold have every achieved and that now banks are the custodians for: store of value.

If Bitcoin becomes the Store of Value in the world, people would move their customer deposits to Bitcoin. And the affect of that would be catastrophic to today’s banks.

Does Bitcoin have a fighting chance to be this?
Well, first of all its achieved an adoption that I think is irreversible. The only thing that could stop Bitcoin now is if governments make it illegal — but even then, it would require every government around the world to act in unison. Because all you need is one island nation, acting an a clearing house, to fulfill the needs of Bitcoin. (And the nation that realises this will become a new financial centre of the world.)

Secondly, the characteristics of Bitcoin are remarkable. What’s going on right now is real work is being generated, to create a hash. That hash and encryption function, will continue to be generated until 21 million Bitcoins are created. And then the supply stays constant!

The significance of this is there is a fixed supply: which means inflation will not exist (rather deflation), a pretty critical feature of where you want your Store of Value. Real work, and hence, value is behind it; and the token itself has a real use beyond being a string of characters — such as acting as a token to authenticate a Blockchain network which will underlay the future Internet.

I agree that there is a bubble right now: the hype driving it makes the price unstable. But I also believe that Bitcoin itself will get to $10,000 in value, without a doubt purely due to human psychology. But that’s not all, it should one day equal in my opinion  all the narrow money of the world which is $29 trillion  (if you want to be conservative, I’ll accept Gold which is $7.8 trillion). So if Bitcoin right now is worth $64,406,377,384 on 16,563,637 coins in supply, it’s price should be $3,888.42 but calculated on all the coins it will ever issue (21m), it’s $3066. But if the market value reaches $29 trillion, then 1 BTC will one day be worth $1, 380, 952 which is a 450x multiple on current prices ($371k if you use gold).

The question about Bitcoin is not about should it exist or not: the truth is, no one can control it. If you believe all the governments of the world will ban it, then maybe — but I believe human’s aren’t that capable on something that isn’t life threatening.

The question about it being a better store of value in the world is also not really a question: by design, it’s superior. (But admittedly the governance mechanisms behind it to create a secure system, are still being worked out and being tested– such as the SegWit2 rollout in November which put this question in doubt.)

Which leads to  the ultimate question, in light of the above:  do you accept it to be the Store of Value in the world? And that is the million dollar question (or, ahem, $1.381m question).

How any country can leap frog in technology

What if I told you we could time travel to 1989 — and be given a forecast of what a new implementation of the Hypertext technology (called the World Wide Web) could do. Would you jump at doing whatever you could to be on top of this trend? Smart phones (Apple’s came out 10 years ago), a technology like Hypertext, also made us rethink how we can use the Internet and recreated the world. Well, it’s 1989 and there is a technology that is poised to do this again.

I’m passionate about the future of health, and I can’t ignore what’s going on with cryptography, artificial intelligence, Internet of Things, and Virtual/augmented reality. But if I had to pick one thing right now, which is ripe for government leadership to leapfrog even silicon valley, it’s this: Focus on blockchain.

It’s a specific technology that’s matured unlike most of these other trends. Its got a hacker community innovating like how I can only imagine when the web started. Its got significant investor interest. It has consumer awareness. It has all the things ready for this to blow up.

This is how you do that:

  1. Make cryptocurrency the same status as any currency. For example, in the US  Bitcoin’s are considered a capital asset which makes it impractical to use unlike regular currency which is treated on the income account. We need to remove this impediment as it makes it not practical.
  2. Offer incentives to businesses working on blockchain. Create a tax free corridor: anyone that that operations in an area is exempt for any taxation. This isn’t to just get the world’s best employing people locally and building technology which will together create an economy of agglomeration, but it will have a flow on affect on other cryptographic matters, such as cyber security which has now become the scariest frontier of warfare right now. Silicon Valley prospered because of technologies building off technologies. 
  3. Force the adoption of cryptocurrency. Require banks to offer it as a service and make all EFT terminals compliant. The moment the economy offers blockchain integrated into the economy — first with currency — we will see an acceleration of blockchain’s potential on the things that are truly exciting (such as Smart Contracts and Distributed Autonomous Organisations)

Implement these three simple policy concepts and it will make that economy the ground zero for blockchain innovation.

As I have already alluded, I don’t think Bitcoin is long term the goal of doing this: it’s the infrastructure that Bitcoin provides that is the exciting thing (ie, the block chain technology which is one of the four technologies that make Bitcoin outside of peer-to-peer, PGP and proof-of-work). The use cases go far and wide: not just for currency, but for things we take for granted like how websites are resolved (like DNS), contracts likes wills, voting, and anything else involving trust (such as simple but critical title deeds).  Blockchain is basically a decentralised database which is in line with the original design goal of the Internet. Efforts like Ethereum are effectively building a computer on top of the Blockchain concept. It’s a whole new paradigm in computing that goes far beyond currency.

But leave that to the entrepreneurs, who are already working on that — I could write many more posts on those ideas alone. But with leadership, anyone one of the three suggestions I’ve made could be legislated into law this year and overnight make that territory a global leader. 

This is what any  country could do to create the world’s best environment to foster this disruptive technology, which I am convinced will create a transformation like what the web did less than 30 years ago. 

 

A decentralised future

Ethereum, a newcomer this year on the Bitcoin scene caught my eye this weekend. What I like about it is that it’s talking about the future block-chain enabled world that has been introduced by Bitcoin, the true innovation of Bitcoin. If you know nothing about Bitcoin or want to get a update on the latest state of the industry,  I highly recommend you read the white paper.

But the reason I am posting about this is because it talks about one of my other favourite new concepts for the future world: liquid democracy. And it combines it together, under the topic of Decentralised Autonomous Corporations (DAC’s), which I often hear in Bitcoin literature but I’ve only come to appreciate today how they would practically work.

In short, mind blown. Liquid democracy and DAC’s represent two of the most groundbreaking advances in the fields of governance in the last decade.

Scenario
Let me give you a scenario of how these three inventions: Blockchain, liquid democracy, and DAC’s would work.

Imagine an organisation such as a government district representing you or the local supermarket store. Now continue this thought experiment and that you and 999 other people are ‘stakeholders’: as a citizen that can elect a representative or you are a member of the organisation that can elect a board of directors, like how non-profits and as for-profits do as shareholders.

Every one of these stakeholders has a “key” and under the principles of DAC’s, if any one of the 551  of the 1000 stakeholders make a vote, it creates a binding decision on the organisation. That itself isn’t the remarkable thing: what’s mind-blowing is that it’s done automatically through “secure multiparty computation”, allowing real time decisions to be processed by computers reflecting the will of the stakeholders.

Now combine that with the concepts under liquid democracy, where these stakeholders can directly vote on any issue — but can also delegate their vote to someone. This concept is called “delegative democracy” and is like a hybrid of the concepts of direct democracy (where citizens get a direct vote) and representative democracy (where citizens elect a representative) — hence the apt term liquid as the direct vote can be delegated to a representative and reverted back to the actual voter in a very fluid way.

And finally, let’s tie this to the blockchain that Bitcoin has introduced to the world: a way to validate decisions.

So let’s say one day, you get an email from your community saying you need to vote on whether to allow a new super market in the area. Or a vote to determine if the super market should sell alcohol. Currently, these decisions are made by shareholders and citizens by their representatives such as management who are appointed by the elected board of directors or elected representatives.

But under the above scenario, you get a direct vote on the matter — along with your 999 other stakeholders. However,  assuming you don’t want to vote, you can allocate your vote to someone else which generalise’s the concept of a board of directors.

Mind blown

If the above doesn’t rattle your brain with its possibilities from how Fortune 500’s operate to the federal government could transform the way they operate from dictatorships disguised as fake democracy where elections simply give the perception of democracy, then it’s because you need to better understand the concepts.

That the (Bitcoin-invented) Block chain is a like decentralised receipt book of transactions that can prove decisions without the need for lawyers, liquid democracy is a new way to make decisions that evolves our current concepts behind direct and representative democracy, and the principles behind DAC’s means we cut the need for people making decisions on our behalf as cryptography has invented a way to determine a group of people (who are pre-authorised) to make decisions in real time.

The significance of Bitcoin is not that it invented this future, but it inspired it as it’s a the first version of  DAC in existence today. Where an entire financial system is controlled by the people, not a government or bank. Humans are replaced by computer algorithms and therefore enabling a decentralisation of power to the very people who are meant to have that power: you and me.

Secondary value is what is holding back Bitcoin

A few nights ago I woke up in the middle night not knowing where I was. It was pitch dark, I couldn’t breathe. In shock, I jumped out of my bed and  found a door before realising what had happened. Gasping for air, all I could think was “Bitcoin liquidity crisis”.
Freshly jet lagged into a summer Australian night that I was still acclimatising  to,  I probably was impacted by the humidity, dehydrated and still confused from all the travel. But the fact I was thinking of the Bitcoin liquidity crisis, I’m going to call  this a premonition of what’s to come.
According to Former US Federal Reserve Chairman Alan Greenspan, Bitcoin is a bubble. I agree.
Greenspace: Bitcoin is a bubble
What makes it a bubble, is unsustainable prices and to which Greenspan says no ‘intrinsic’ value. This is where I disagree, but does point to a real challenge with any crypto-currency.

While the innovation right now is on establishing exchanges which create a base level of liquidity, Bitcoin suffers from one critical weakness in its design. Fixable I might add, but critical.

Secondary value
On a base level, the creation of exchanges will solve the liquidity problem: more banks, more currencies, faster conversions, lower fees — will allow more people to convert their government-backed fiat-currency into Bitcoins. This will help in developing the maturity of the currency.

But it doesn’t solve the confidence issue that will impact ultimately its liquidity. This is because Bitcoin or any other crypto-currency has no secondary use if the value falls. It’s going to collapse when the social compact loses confidence. Greenspan is wrong in saying Bitcoin’s doesn’t have any intrinsic value because the algorithms developing the hashes’s are the result of mathematically complex equations ‘mined’ by a global network of  brute force computing. But he is partly right, in that those outputs in the algorithm’s don’t have any secondary value. Unlike gold which has been used as a form of currency as well as a metal for jewelry, Bitcoin’s cryptographic puzzles currently don’t have a secondary use aside from validating the blockchain.

Arguably you can say the same about any other fiat currency: if a government and society didn’t think the USD has value, the pieces of paper would be useless. But unlike the USD, Bitcoin does not have a government guaranteeing the value of the currency.

Long term this won’t be as big a deal, because if you look at the USD, no one questions the liquidity of the US government. Though with a lack of confidence, the same issues would happen if everyone in the world cashed in their Greenback (and yes, the US government wouldn’t handle that crisis and the world would lose confidence). This issue however will hold back the initial foundation of the system as it will be the basis behind a liquidity crisis due to confidence.
Which is partly why we need a Bitcoin bubble: it will lay down an infrastructure that will be a sunk cost that will result in future use “because it’s there”. But if we could invent a way to give Bitcoin secondary value by finding a way to leverage the block chain to give value elsewhere in the world (possibly the mathematical puzzles become a source of validation for the world?) then this would inject much needed confidence in the system to make this a true global currency.

Bitcoin makes sense for the future

Bitcoin fascinates me. Whether it’s the future of currency itself I don’t know, but it will pave the way for the future so it’s worth studying.

There are two reasons that people claim make Bitcoin flawed.

The first is that it’s based on ECDSA (Elliptic Curve Digital Signature Algorithmwhich consists of a private key (a secret number known only to the person that generated it), a public key (a number that corresponds to a private key which is calculated from the private key but that is very difficult with current computing to reverse engineer to predict a private key), and a signature (a number that proves an operation took place that  used a hash and the private key). Values can be determined without the private key ever being disclosed, so that a bitcoin can correspond to a public ledger to prove the authenticited of ownership — for example, an algorithm can determine with the public key on a signature to determine it was produced by a hash and the private key, without needing to know the private key.

And so the critique goes, if someone can build a sufficiently powerful quantum computer, Shor’s algorithm will enable someone to steal bitcoin’s at will as they can crack the secret of someone’s private key. But basically, it’s practically impossible for this to happen. I’m not crypto expert, but I’ll leave this for others to digest further.

The second critique is due to the known limitation that bitcoin will one day cap at 21 million units. If bitcoins go missing, we will never be able to replace them — such is the case with physical currency today which goes out of circulation (but a central authority issuing it can reprint them). And inherently, Bitcoin is considered to be deflationary — the problem with deflation is the decreased price level of goods and services. Meaning, because it’s got a future guaranteed scarcity it will get scarcer and lead to deflation so therefore it’s doomed.

This is what I want to explore further because it’s worth clarifying some fundamental assumptions about the world.

What is value?
Let’s start with a functional definition of value. “Value is energy applied to resources where the perceived utility of the output is more than the inputs.” That definition implies there are three sources of value in the world: energy, resources, and outputs that have used the application of energy on resources and becomes a transformation. And the utility of a transformation, is different from say energy and the resources that went into it, simply due to perception of it. Basically, value is at core about utility.

Resources are finite: we only have a limited amount on earth that we can use. And most of it is not usable, as we don’t have the capacity to extract the resources in a usable way. Energy on the other hand, by the human definition, is unlimited — the sun sends 1.KW for every square metre of the earth surface for free. But what limits energy is the ability to capture it, store it and transport it — so therefore energy has value. We need energy to function: animal and plant life need it to function, and we need it to extract resources as well as apply it to transform resource into new products.

Is energy in itself valuable? Well, only if we use it: if a plant sits in the sun, it’s free — as does a human who will get Vitamin D that helps it function. Just because it’s free though doesn’t mean it doesn’t have value: it’s just the price is low. Humans also need other vitamins to survive, and it requires the expenditure of energy to acquire future sources of energy — that energy could be valued as time to hunt down animals for example.

Do resources have value? If it’s utilised, it has value — and the more it’s used, the scarcer it becomes for other uses which is why it gets regulated by price when there are competing seekers of the resource. Like energy, the question isn’t if there is value: the issue is what is the price of that value. It’s how to price that utility to regulate its usage.

Theoretically, you could say the current available energy in the world that can be used and the current available resources are what is value in the world, as well as the products created through the transformation of resources with energy. Value is what the total utility in the world is. And if there are no competing uses of those pieces of value, then prices are practically nil: but once there is competing needs for limited pieces of value like resources, that’s when we see the price increase.

And that is, why fundamentally, all value is tied to scarcity: the scarcer the value (supply) and the higher the demand, the higher the price.  This is fundamental economic theory which is the study of how to best allocate limited resources in an world that is based on the assumption of unlimited wants — which theoretically, makes sense. What breaks down is that interpretation of the theory.

For example, it’s fine to say there are unlimited wants in the world — but that’s a assumption that says there will always be competing demands for resources so therefore everything needs a price. Which again, is fine: it’s just this assumption of an assumption needs to assume a more fundamental assumption: a price of zero doesn’t make something less valuable than the same resource which has a price of more than zero. If you can buy a diamond for $1 but it normally would be valued $1000, that doesn’t mean it’s less valuable fundamentally: it just has less competition and so therefore less cost to acquire.

What is currency?
Arguably, you could say the sum of value in the world is all the stored energy, available resources, and transformations in the world which has utility. The world’s currency system should be tied to that: if you could exchange all the value in the world, it should be equal that.

Currency should be a way to store value and transport it. The energy I applied with my time which created more perceived value than the energy itself in the form of knowledge,  I want to store for a future use where I can exchange that for something of similar value. Therefore, a currency needs to have a consistent form of pricing (to make value comparable) and it ideally has a stable means of being valued (ie, storing it a year ago should theoretically be valued as the same as storing it today).

But the hard thing about utility  is that it’s hard to measure at the one point in time –even though we know there is a fundamental fixed amount that can be used in the world. But that’s why the assumption that a currency should have a fixed supply makes perfect sense: the price mechanism of currency adjusts for changes in utility (assuming the supply of currency doesn’t degrade, which is another factor why modern day currency can adjust in value).

Bitcoin’s fixed supply
Which brings us to the question: does Bitcoin having a fixed supply make sense? Yes.

But what about the risk of “deflation” in the world due to a fixed supply? Well, it’s not that value in the world goes does — it’s just the pricing of that value might go down.

The above discussion I hope answers those questions.

And what about if there are missing bitcoin’s in the world, which creates a supply constraint on this new currency? Bitcoin’s are divisible up to 8 decimal places which means one bitcoin has 100 million components (yes, they have a name: called a “Satoshi”). Ignoring the clear economic incentive to not lose Bitcoin’s, lost coins get lost in the noise and this divisibility allows it to adapt. With 21 million final bitcoin’s divisible by 100 million, that means 2.1 quadrillion units of currency or Satoshi’s. To put that in comparison, in 2009 there was approximately 8.3 trillion US dollars in the world or 0.0083 quadrillion cents. If one cent was one Satoshi, that would be 2100 trillion US cents or 21 trillion US dollars.

Some say the value of the US economy to be 188 trillion dollars (different from GDP, which simply accounts for   spending in one year). Assuming the US economy in 2009 accounted for one quarter fo the world economy (based on GDP), we can assume the world has a price on the value in the world of about 750 trillion US dollars or 0.8 quandrillion.

If the total *value* of available Satoshi’s in the world one day equals that amount (One Satoshi equals 0.35714285714 US cents  or 750 trillion divided by 2.1 quadrillion) — then who cares if a few bitcoin’s get lost along the way. What we have now is a currency that does what currency is meant to do: store value for the exchange of value in society.